Is Another European Bank Crisis Starting?

European banks, which have seen equity prices under pressure for some time saw those declines accelerate recently. More dangerous, with a greater possibility of impacting global markets is the rapid deterioration in the bond market. Complex "hybrid" instruments like CoCo's have been most heavily hit, but bank credit spreads in Europe have been widening as well. It is quite possible that this spread widening has been a bigger reason for U.S. stock market weakness in the past weeks than even oil.

It is important to know what is happening to European banks and only then case you assess the risk of whether this recent price action is merely a blip or the harbinger of worse to come.

Euro Stoxx Bank Index Since August 2015 (Bloomberg)

European banks first got hit in August last year along with the rest of the global markets on the “first” Chinese devaluation. They slipped another 7% in December, but have dropped almost 22% year to date. (that makes XLF’s -12% ytd return look good by comparison).

Of greater concern, at least to me is the recent performance of credit spreads.

ITRAXX Senior Financial CDX Index (Bloomberg)

This index is based on the CDS spreads, at the senior unsecured level of 30 European financial institutions (primarily, though not exclusively banks). Spreads have blown out for a relatively benign 70 bps in December (from lows of just over 50 in March – post Draghi’s launch of QE) to a more concerning 121 bps at Friday’s close.

That level is nowhere near to the peaks reached at the height of the financial crisis or even in the early healing stages, but it is a concern to see levels spike so quickly.

The story gets more interesting once you start examining a few specific instruments.

These CoCo’s were issued at just over par in late 2014 and spent much of the past year trading between 95 and 102.5. The CoCo's outperformed bank equities through most of 2014, but that all changed in the past few weeks. These DB CoCo’s have dropped over 15% since late December. These CoCo's are complex instruments. They count at “Additional Tier 1” capital for Basel III purposes. To count as that level of capital, the CoCo's have features that allow coupons not to be paid under certain circumstances and even "mechanical" conversion triggers. (You must read the offering memorandum for any particular bond to understand it fully - this is meant as superficial description of CoCo's and not detailed analysis of the particular bond ).

What Happened?

I pointed out earlier this week (here) that the current fixation with oil as the main driver of U.S. stocks was potentially misleading. The widening in European Bank credit spreads has been a topic of conversation among many macro investors that I think has already started to impact the broader market. But before you can determine how important this is to your portfolio, you need to start to understand how we got to this point.

To some extent, one little known bank, Novo Banco, started this all. Right at the end of last year, Novo Banco seemed to arbitrarily determine which debtors would be winners or losers – As Tracy Alloway writes on December 30th (click here for full article) "Investors Aren't Very Happy With Portugal's Bank Bond Decision". Maybe it was the timing or the small size of the bank itself, but this seemed to fall under the radar screen of most U.S. investors.

But, over time, it seems that this apparently arbitrary decision on how to treat various lending classes at least partly triggered concerns of “if they could do it there, they could do it anywhere”. There are discussions about what could happen at other weak banks and if this could set a precedent.

Then the market was impacted by weak results at DB, and a comment, meant to be reassuring that seems to have actually made the market more fearful.

“Based on the preliminary 2015 financials, we believe we have sufficient ADI and payment capacity under the German GAAP to pay AT1 coupons,” said Chief Financial Officer Marcus Schenck on the company’s earnings call Thursday, according to a transcript. “We believe we have sufficient general reserves available to cover any shortfall.” (source Bloomberg, January 29th)

The market for DB CoCo's initially responded positively, but then reversed course and closed Friday near the lows. One possible explanation for the reaction is the possibility that by addressing the issue, he brought it to the forefront of investor minds and caused fear where he intended to inspire confidence?

In any case, the combination of weak bank earnings for many European banks, a growing disillusionment with central banks’ ability to mitigate every risk, and a potentially arbitrary process for determining which lenders win and which lose, has caused credit spread widening to accelerate in Europe.

Is it all Bad?

While spreads have widened recently in most cases they are nowhere close to the peak seen at the height of the crisis.

The scale on this chart makes it difficult to read clearly, but that is the point. Credit spreads, in spite of their recent spike higher are not even back to levels seen in 2013, and certainly not close to where they were at the height of the crisis in late 2011. One thing that is worth pointing out is that while Mediobanca remains the worst (in green) and CS remains the best (in orange) we have seen SocGen (in blue) which was second widest during the crisis, remain stable and is trading close to CS. DB, on the other hand, has slipped and is trading more like Mediobanca than CS (it peaked at just over 300 and closed on Friday at just over 200).

So in general, senior unsecured credit spreads are far from their highs, and that while CoCo's are bonds, they have a lot of equity like qualities in a stressed environment (as they were designed to) so investors have to be careful to sort out useful and relevant facts from alarming statistics that might not be more broadly applicable.

While I think it is unclear whether central banks can really impact the economy in the way they hope, I do think that they shown themselves to be successful at what they were originally intended to do - support the banking system. While we cannot rely on Draghi, we should also be careful doubting his ability to support banks since he knows how crucial it is, and is the one area that he has plenty of tools at his disposal that are truly within his mandate.

While I do not know where we go from here since there are reasons to be concerned but also some to be optimistic, it is something investors need to be aware of, as it has the potential to impact the global economy and stock markets.

Disclaimer: The content provided is property of Peter Tchir and any views or opinions expressed herein are those solely of Peter Tchir. This information is for educational and/or entertainment purposes only, so use this information at your own risk. Peter Tchir is not a broker-dealer, legal advisor, tax advisor, accounting advisor or investment advisor of any kind, and does not recommend or advise on the suitability of any trade or investment, nor provide legal, tax or any other investment advice.

I focus on global macro and current market drivers, with an emphasis on the fixed income markets. I have 20 years of experience as a trader, structurer, and strategist in markets ranging from Treasuries and High Yield bond trading, to CLO’s, to CDS indices. My unique back...